Debt financing for startups can take a variety of forms and, depending on the form and source of financing, may co-exist with equity investment in your business. Debt can be used to benefit all shareholders, including founders and investors, to fund the growth of the business without further diluting the ownership position of the existing shareholders.

Most early-stage startups cannot borrow from traditional sources, such as banks and financial institutions, because they do not have a track record of cash flow or liquid assets to make required loan and interest payments. Banks and other lending institutions will not secure a debt based solely on a company’s intellectual property (IP), which is a real challenge for early-stage technology companies.

Early-stage equity investors tend to limit the type and amount of debt that a company may have through the terms of their investment instrument. This is done for a number of reasons:

  • Investors do not want their investment to be used to repay your startup’s existing debt.
  • They do not believe there is enough certainty in your business’ current financial plan for you to commit to future payments of principal and interest.
  • Investors do not like debt structures that require your IP to be pledged as security for a loan. Venture capital firms (VCs) view the IP as an asset that may be sold or licensed to provide some financial return on their investment in a downside situation where the business is unable to execute on its plan.

Later-stage startups tend to have more flexibility to add debt financing from several sources, as they have cash flow from operations to use for required debt principal and interest repayments.

Considerations for debt financing

When determining the types of debt instruments available to your company,  you will want to carefully consider the complexity of managing multiple secured creditors in your ongoing business operation. This includes the event of a default on one or more loans, when secured creditors will have the right to operate the business and sell the assets to recover their debt and the interest owing on the debt.

Startups or businesses with multiple secured creditors must negotiate agreements (also known as inter-creditor agreements) to determine:

  • The ranking of creditors with respect to their collateral security interest in the company’s assets.
  • Their rights with respect to business operation and liquidation activities, such as appointing a receiver or managing your business’ affairs.

References

Canadian Banker’s Association. Retrieved April 9, 2009, from http://www.cba.ca.

Canada Business Services for Entrepreneurs. Retrieved April 9, 2009, from http://www.canadabusiness.ca.

Houston, T., Johnson, A., & Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at , now available at http://www.lexology.com/library/detail.aspx?g=7c476ef3-67a9-4a33-8053-05331cb29e6a

Royal Bank of Canada. Retrieved April 9, 2009, from http://www.rbcroyalbank.com/business/financing/small_bus_loan.html.